Diminishing marginal returns and diminishing interest in left-wing parties

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Economic Models: from theory to application n.2

Diminishing marginal returns is a concept of paramount importance in economics. Defined as an increasing disinterest in anything, diminishing marginal returns are found in most economic fields, representing the mere nature of human beings when it comes to making a choice.

For many years, the welfare state has been the main selling point of the Left. Defending a redistribution of income through taxation and financial aid in order to make society safer and better, the welfare state is criticised by some economic schools as being an intrusive intervention of the state into the private matters of economic agents.

Support for or against political parties defending the welfare state might appear to depend upon which economic school one believes in, or upon one’s ethics and moral beliefs. Perhaps, however, the interest in defending the worse-off members of our society is also prone to diminishing returns.

Europe saw welfare states flourish in the 20th century, with many European countries putting social security programmes in place. The European Union itself promotes many financial aids and other safety nets to ensure the protection and well-being of its citizens, but this interest has diminished over time. Is this the result of diminishing marginal returns?

What are diminishing marginal returns?

“Diminishing marginal returns” are three words which read like they shouldn’t be together. One could define diminishing marginal returns in a technical manner, explaining concavity of weird economic functions and employing many obscure terms; but instead, let’s spare ourselves from a collective headache and leave this mathematical nonsense on the side to focus on the intuition behind this concept.

Imagine you are given a blank sheet of paper, and nothing else, and you are asked to draw a house. You are quite unhappy, as without a pen, you cannot draw anything. You are unable to respond to this request.

Suppose now that you are given a black pen, or any coloured pen. Now you can draw the house. Your satisfaction increases drastically, as you went from being unable to do anything to being able to do almost everything with this pen and paper. You can draw, you can write. This step between no pen and a black pen was a jump towards your freedom and enabled your ability.

Now, you are given another pen – a red pen. You can now add colours to your drawing, maybe express shadows or differentiate the roof from the walls in this drawing of your house. Your satisfaction increases – but it increases by less than when you were given the first pen, because while this red pen lets you explore wider areas of your creativity, the very first pen you were given allowed you to go from nothing to almost everything. Hence your satisfaction increases, but by less than previously, that is in a diminishing way.

You are given many more coloured pens, until a point is reached at which you have all the colours that you could imagine; you are then given this beige-with-a-dash-of-ochre-coloured pen that you did not have previously. Your satisfaction increases, but by less than before; sure it is useful to have this pen, if you need this exact colour one day, but you might never need it, and it does not unlock that much of your potential. Hence, your satisfaction increases again, but by way less than previously.

This is the idea behind diminishing marginal returns. When you start with nothing and are given something, the returns increase – that is your satisfaction increase in this case – will be greater than any subsequent incremental increase. In economic terms, the marginal returns are decreasing; the return of one extra unit increases your satisfaction, but by less than when you received the previous additional unit.

Wow! Diminishing marginal returns are so great – but what’s the point?

Diminishing marginal returns are great because they are a pattern that we find in many aspects of social science – and maybe of life more generally speaking. They are crucial as they allow economists to capture economic agents’ behaviour. Often linked to means of production or to the utility – an economic measure of agents’ wellbeing – diminishing marginal returns might be found in broader areas of economics, and more generally in broader areas covering agents’ behaviour.

In particular, Inglehart and Flanagan (Inglehart & Flanagan, 1987) argue that this phenomenon of decreasing increases can be found in politics, and in particular in the support of redistributive policies. Upon studying several European countries, Inglehart found a weakening positive relationship between support for the welfare state and income equality, leading them to conclude that redistributive policies are accompanied by diminishing marginal returns.

Their idea is the following: when a society is greatly unequal and when income inequality is high, redistributive policies benefit a large share of the population. Indeed, where income inequality prevails, the richest citizens’ share of total income is substantially higher than their share of the population; for instance, the richest 10% of citizens may own 50%, 60% or even 70% of the total income, leaving less than half of the country’s income resources to the 90% remaining population. While perfect equality is unattainable, a great level of inequality as described in the example above can lead to discontent in the poorest parts of the population, who will demand redistributive policies to palliate for this inequality. When this poorest part composes the largest share of the population, support for a larger welfare state might win elections.

Yet, as a welfare state is implemented and equality improves, fewer people benefit from redistributive policies. The share of the population that truly benefits from it, and hence that supports it, becomes a minority that is insufficient to lead to the victory of parties fighting for more redistribution. That is, as the welfare state becomes more generous, support for more of these policies decreases. If the returns of expanding the welfare state are greater income equality, marginal returns of the support for the welfare state decrease as the welfare state expands; support for more welfare does increase with income, and yet the rate of increase decreases, until it reaches a stagnant – or even decreasing – point. Hence, support for the welfare state is a victim of diminishing returns.

… so what’s going on in Europe?

When comparing it to its counterparts, Europe is often seen as a model of the welfare state; European countries, and Nordic countries in particular, are often praised for their reduction of inequality and their well-functioning welfare states. Arguably this achievement is nothing but the result of redistributive policies implemented by left-wing parties during the 20th century.

Data source: World Inequality database